Cumberland Advisors Market Commentary – MMT and Camp Kotok

Author: Robert Eisenbeis, Ph.D., Post Date: August 26, 2019

As David Kotok noted in his description of the intellectual discussions that occurred at Camp Kotok in Grand Lake Stream, Maine, one of the topics was so-called Modern Monetary Theory, or MMT.[1] There were four panelists, who were asked to take different sides for the sake of argument, representing positions from the most favorable to the most skeptical. The discussion was lively, but MMT was generally greeted with nervous skepticism. Reactions were skeptical because of what the theory proposes, what it assumes, and what it fails to address, i.e., inflation dynamics and the mechanics of how government will respond if and when its spending leads to inflation. The nervous reaction was rooted in the fears of many that MMT is inevitable.[2]

So let us look at the basics of MMT and try to tease out why the Camp Kotok group was so queasy about the concept.[3] First, MMT is not new and is basically a recasting or a heterodoxic synthesis of several macro theories describing what is basically a fiscal policy approach, not a monetary policy approach, to inflation, economic growth, and full employment. (As John Maynard Keynes once observed, “Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”[4]) Despite the title, MMT essentially says that the only role for monetary policy is to print money to enable the government to spend.[5] It is a form of chartalism, which considers money as a state-controlled asset that can be employed to achieve public policy objectives. It is rooted in the ideas of several now long-passed economists, including Abba Lerner’s concept of functional finance but also ideas expressed by Georg Friedrich Knapp, Alfred Mitchell-Innes, Hyman Minsky, and Wynne Godley, just to name a few “defunct” economists. There are five basic tenants of the so-called theory:

Governments can print money to pay for goods and services without the need to collect funds in advance through taxes or debt issuance.

Note: The key underlying assumption is that the central bank is under the control and direction of the Treasury and creates however much money the government wants – either by supplying currency or simply by increasing the government’s spendable deposit at the central bank. In its pure form, it also does not admit, or discount, the fact that other forms of nongovernmental money can exist at the same time. The proponents sweep aside the current separation in the US between the Treasury and Federal Reserve; under law, the Fed cannot lend to the government nor buy debt directly from the Treasury. In fact, an act of Congress would be required to change the Federal Reserve Act to permit the kind of Treasury/Fed linkage envisioned in MMT.

The government cannot be forced to default on debt denominated in its own currency since it can always print money to pay back what is owed.

Note: The assumption here is that a country is able to borrow in its own currency, and hence its currency is essentially a reserve currency asset. Countries that borrow in another currency, as has happened in some Latin American countries, can default and have, de facto, done so.

The theory assumes that inflation will not accelerate until the economy has achieved full employment.

Note: The theory as well as its proponents are mainly silent on the underlying inflation dynamics and seem to assume no upward creep in inflation until after full employment is reached. In this sense there is no tradeoff between employment and inflation as assumed, for example, by the Phillips curve analysis.

When inflation does appear, government can simply raise taxes and issue debt to reduce the money in circulation and to stem any inflation that may have manifested itself.

Note: It is assumed that Congress with impose taxes and the Treasury will issue debt in a sufficiently timely fashion to shut down inflation. The theory is silent regarding both the politics of how taxes are imposed and how and when tax increases are reversed when inflation declines to an as-yet-undetermined but acceptable level.

It is assumed that government debt issuance does not compete with private sector borrowing and does not crowd out private sector investment.

Note: This assumption rests on the idea that because government doesn’t need to borrow or tax to generate revenue, government debt issuance serves only to extract money from the system and does not compete with other private sector investments.

Critics have noted many flaws in the theory, especially as it applies to the US.[6] First, under MMT, proponents claim that a government can fund itself by printing money by having the central bank create a Treasury deposit, which when spent becomes high-powered money within the banking system without the need to issue public debt.[7] This construct exists because in MMT the central bank and Treasury are considered one entity. The government purchases goods and services with printed money or a with draft on the Treasury’s account with the central bank and when spent this is how an economy obtains money to conduct business.[8] Such government purchases are viewed as costless since printed money bears no interest and government spending is a principle source of job creation and fiscal stimulus. This fiscal activity can continue until full employment is achieved and inflation breaks out. Then, to control inflation, government simply imposes taxes sufficient to reduce the outstanding money supply to the point where price stability is achieved. Proponents, as noted above, conveniently ignore the political realities of how tax policy is set and even the fact that it is Congress and not the Treasury that determines tax policies. As we consider the alternative arrangement envisioned in MMT, we might note that the histories of countries where central banks lack independence are fraught with examples of hyperinflation and instability, Argentina being but one prime example.[9]

Second and most importantly, the current separation between the Federal Reserve and the Treasury means that the only way the Treasury can get balances at the Fed is to transfer tax revenues collected in bank tax and loan accounts from the receiving bank to the Fed by crediting the bank’s reserve account and debiting the Treasury’s account with the Fed. That is why the Treasury’s access to funds is endogenous, not exogenous as proponents claim.[10] When those funds are spent, they flow back into the banking system by increasing bank reserves and decreasing the Treasury’s balance, with no impact on the size of the Fed’s balance sheet. The only way high-powered bank reserves are created is through the Fed’s buying Treasuries in the open market (but not from the Treasury) or by redeeming currency returned to the Fed. When the Treasury engages in deficit spending, it issues debt in the market; the public’s asset holdings shift in composition from deposits to Treasuries; Treasury balances at the Fed go up; and when these are spent, bank reserves go up and Treasury balances go down with no change in the size of the Fed’s balance sheet. But now Treasury is spending in lieu of the private sector. As was the situation during QE in response to the Great Recession, the Federal Reserve’s holdings of Treasuries increased on the asset side, and reserve balances increased on the liability side of the Fed’s balance sheet, the private sector Treasury holding (outside the Federal Reserve) declined, and bank reserves (and the public’s demand deposits) increased.

The skepticism about MMT voiced at the Camp Kotok meeting was rooted in the belief that the theory would not work in practice, and the nervousness was due to the fear that MMT implies a way to achieve the spending objectives of many of the current presidential candidates. Indeed, one of the proponents, Stephanie Kelton, was an advisor to Bernie Sanders during his 2016 presidential campaign. The fear was heightened by the fact that neither political party, based on the huge deficits embedded in the recent budget agreement that was passed into law, had the will to be disciplined about the country’s fiscal situation. All in all, the conclusion was that MMT was a theory that promised manna from heaven, and as such it had great appeal, but with potentially disastrous consequences for our country.

[3] This account is best viewed as a Cliff Notes version of the theory. Much has been written on the topic, but readers can find references on Wikipedia. And for a fairly concise discussion of both the nuances of the theory and critiques of it, see Modern Monetary Theory: A Debate, Political Economy Research Institute, University of Massachusetts Amherst, which includes the following papers: Brett Fiebiger, “Modern Money Theory and the ‘Real-World’ Accounting of 1-1<0: The U.S. Treasury Does Not Spend as Per a Bank; Scott Fullwiler, Stephanie Kelton, and L. Randall Wray, “Modern Money Theory: A Response to Critics;” and Brett Fiebiger, “A Rejoinder to ‘Modern Money Theory: A Response to Critics’”; January 2012, Working Paper Series Number 279 (http://www.peri.umass.edu/fileadmin/pdf/working_papers/working_papers_251-300/WP279.pdf).

[7] This is an admittedly bare-bones description of how the theory supposedly works.

[8] This setup ignores the fact that most economies have not only currency but also private monies like bank deposits.

[9] It is interesting to note that in 1900 the US and Argentinian economies were the same size in terms of GDP.

[10] The two exceptions are that the Treasury has in the past issued greenbacks to fund the Civil War and silver certificates later on, but these were tied to gold and silver, respectively.

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